econstor
A Service of
zbw
Make Your Publications Visible.
Leibniz-Informationszentrum
Wirtschaft
Leibniz Information Centre
for Economics
Gesheva, Nadezhda; Vasilev, Aleksandar
Preprint
Revisiting the Invisible Hand Hypothesis: A
Comparative Study between Bulgaria and Germany
Suggested Citation: Gesheva, Nadezhda; Vasilev, Aleksandar (2016) : Revisiting the Invisible
Hand Hypothesis: A Comparative Study between Bulgaria and Germany
This Version is available at:
http://hdl.handle.net/10419/144162
Standard-Nutzungsbedingungen:
Terms of use:
Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen
Zwecken und zum Privatgebrauch gespeichert und kopiert werden.
Documents in EconStor may be saved and copied for your
personal and scholarly purposes.
Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle
Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich
machen, vertreiben oder anderweitig nutzen.
You are not to copy documents for public or commercial
purposes, to exhibit the documents publicly, to make them
publicly available on the internet, or to distribute or otherwise
use the documents in public.
Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen
(insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten,
gelten abweichend von diesen Nutzungsbedingungen die in der dort
genannten Lizenz gewährten Nutzungsrechte.
www.econstor.eu
If the documents have been made available under an Open
Content Licence (especially Creative Commons Licences), you
may exercise further usage rights as specified in the indicated
licence.
Revisiting the Invisible Hand Hypothesis:
A Comparative Study between Bulgaria and Germany
Nadezhda Gesheva1
Aleksandar Vasilev2
American University of Bulgaria
Abstract
This paper examines Adam Smith’s concept of an Invisible Hand of the market in light of the underlying
assumptions for the theory to hold. Furthermore, the study focuses on Total Factor Productivity as a measure of
efficiency of resource allocation, employs growth accounting in Bulgaria relative to a frontier country
(Germany), and tries to explain the Total Factor Productivity gap with the difference in the quality of institutions
and economic freedom performance (where the latter is based on the Freedom Index Indicators). Satisfactory
results have been obtained, favoring the hypothesis that freer markets perform better and a “catching up” effect
of Bulgaria’s Total Factor Productivity levels towards those of Germany has been observed. Finally, the study
provides policy recommendations facilitating the Invisible Hand Process in Bulgaria for a more rapid
convergence towards Germany’s productivity levels.
Keywords: Invisible Hand of the Market, Free Market Economy, Total Factor Productivity, Convergence.
JEL Classification: C82, D5, D82, O11
1.
2.
3.
Introduction
“An Inquiry into the Nature and Causes of the Wealth of Nations” is Adam Smith’s most influential
work that has had an impact on the world of economics since its publishing in 1776. It became “the gospel of
free trade and economic liberalism” (Copley and Sutherland 1995). One of the most essential propositions in
modern economics had been made in this classic book – competitive markets are able to allocate scarce
resources efficiently when governments do not play a dominant role. Smith defined the term “wealth” of a
society by the annual production of its labor and not by the amount of gold that a society owns. A good way of
expanding this wealth, he suggested, is by the division of labor - when people specialize in the field that they are
most productive at, and trade these produced goods and services for the one they need, this leads to an economic
growth. According to Smith, a certain “natural liberty” is encoded in human nature – a condition in which
individuals tend to pursue their own goals. Nevertheless, the pursuit of an individual’s own interest results in the
increase in common wealth, although this is achieved unintentionally. Smith used the metaphor of an Invisible
Hand to illustrate the natural instincts that motivate and model the behavior of the participants in a market so that
a greater variety of goods and services are being offered and received (Walton and Wykoff 1998). The process is
called invisible simply because it is not intentional. Adam Smith argues that the “system of liberty” – interaction
between these self-serving individuals not hampered by any excessive regulations – would lead to an
optimization point (i.e., Pareto optimization).
A burning issue - is the Invisible Hand of the market still relevant?
In theory, three types of economic systems exist – free market economy, command economy and mixed
market economy. The former is characterized by the limited role of the government, while in the latter the
government is in full control of all political, economic and social matters. In practice, the third option - mixed
market economy - is the most widespread in the 21st century. Almost every economy is a blend of the free
market and the command economy types. Today, almost 250 years after Adam Smith’s revolutionary idea was
first shaped, the modern citizen of the global village enjoys a profoundly different economic situation. Thus,
there is a need to transform Adam Smith’s theory into modern day language. One could interchange “is the
Invisible Hand still relevant” with “are societies that rely on economic freedom, healthier and more productive”.
Nowadays, the burning issue is what proportion of mix from free market and command economy will produce
the most successful and productive economy? Taking into consideration the above discussed theory of Adam
Smith, the consequently provided arguments and the conducted analysis of the main drivers of economic
prosperity, this study advocates in favor of the relevance of the Invisible Hand of the market.
Clarification of the assumptions behind Smith’s Invisible Hand Process
Although the mechanism of the Invisible Hand of the market (IHM), derived as an economic theory in
the middle of the 18th century, has no direct reference to the field of Mathematics, it is important to acknowledge
1
2
[email protected]
[email protected]
Nadezhda Gesheva
that both have common ground. Similarly to a mathematical statement, the IH theory consists of two parts: the
hypothesis or assumptions made, and the conclusion drawn. One should emphasize the fact that the Invisible
Hand of the Market is working if and only if specific conditions are fulfilled, and fails when they are not present.
The validity of Smith’s theory is highly dependent on a set of factors ranging from the economic, political and
social spheres. To begin with, the essence of the Invisible Hand hypothesis lies in the low degree of government
intervention in the economy (i.e. laissez-faire policy), including no price controls and stable inflation leading to
prices serving as an efficient market clearing mechanism. In addition to this, a society needs to be free of
informational asymmetries and confusion in order for the market to clear at the existing prices and to achieve
dynamical equilibrium levels.
What is more, the market place must have low barriers to entry and exit, reasonable transaction costs as
well as numerous market participants of equal size. These assumptions comprise the major requirements for a
free market system to operate properly, implying that they are not specific hard-to-attain requirements for the
validity of the IHM but a necessity for every free market economy. The political and social conditions represent
a vital background for implementing the Invisible Hand Mechanism: the efficiency with which the Rule of Law
is enforced, the low crime rate and the protection of human rights are a necessary prerequisite for the validity of
the theory.
On balance, the above mentioned assumptions serve as a hypothesis for the Invisible Hand statement. If
all the conditions are present, then Smith’s Invisible Hand allocates limited resources (scarce goods and labor
force) in the most efficient way (i.e., in a Pareto efficient way), thus promoting economic prosperity (please,
refer to Table 3.1).
Table 3.1: Describes the necessary conditions for the IHM to work.
Assumptions/Hypothesis
Conclusion
Laissez-faire economy
No informational asymmetries or confusion
Low entry and exit in the market
If
Uniformity of market participants
Low transaction costs
Rule of Law
the Invisible
Hand of the
Market allocates
limited resources
are present, then
efficiently. Thus,
promoting
economic
prosperity.
Protection of Human Rights
Source: Own Estimation
The structure of the study is along the following lines. After transforming Smith’s theory into modern
day language and clarifying that the Invisible Hand works only if a set of assumptions are present, part 3
examines instances of market failure. Those market failures imply the non-existence of the IH when one of the
assumptions is not met – the lack of adequate information. The discussion relies on economic findings of George
Akerlof and Joseph Stiglitz. The following section is devoted to Schumpeter’s Creative Destruction process
acknowledged by this paper as a process that has much in common with the IHM. The 5th part illustrates a
quantitative method (Growth Accounting) used for measuring the influence of IH on economic prosperity by
introducing the concept of Total Factor Productivity (TFP) and associating it with Freedom Index Indicators. A
thorough analysis of the drivers of economic success in Bulgaria and Germany is presented further backed by an
empirical data analysis using dynamic correlation estimations in section 6. The following section provides
evidence in favor of Bulgaria’s TFP convergence towards Germany’s TFP levels. In addition, the 8th section
highlights the major impediments standing between Bulgaria and the frontier country, and proposes suggestions
for improvements in the lagging components.
Appendix A further clarifies the Growth Accounting Methods used in Section 5 and provides detailed
quantitative methods for generating the TFP series for Bulgaria and Germany, while Appendix B further
illustrates the analysis conducted in section 6 with the use of thorough correlation tables and convergence
graphs.
Although economists (J. Keynes, J. Stiglitz, St. LeRoy, J. Schlefer, etc.) have studied the extent to
which Smith’s theory is viable, the analysis provided in this paper does not seem to have been formally derived
in the previous literature. Both - the Invisible Hand’s quantitative measure and the concentrated study of
Bulgaria’s convergence towards Germany in terms of Freedom Indexes as a manifestation of the Invisible
Hand’s process - are an intriguing supplement to the current economic literature.
2
Nadezhda Gesheva
4.
4.1
4.2
Factors that hinder the work of Invisible Hand of the Market
Information economics is a broad microeconomic theory that examines how information systems affect
economic decisions, and thus hinder the work of the Invisible Hand of the market. Extensive research on this
issue was originally motivated in 1945 by Friedrich Hayek with the publication of his “The Use of Knowledge in
Society” but the following section focuses on information disorder research made by the Nobel Memorial Prize
in Economic Sciences winners in 2001– George Akerlof and Joseph Stiglitz. This study discusses instances,
suggested by the above mentioned economists, where the price mechanism fails to coordinate efficiently
economic activity and the division of labor. Possible ways of resolving information asymmetries are also
examined.
George Akerlof – Raise of Transaction Costs due to informational asymmetries
Information asymmetries inevitably arise in a market economy, causing adverse selection. The famous
economist George Akerlof sheds some light upon this issue with his work “The Market for "Lemons": Quality
Uncertainty and the Market Mechanism”. The paper asserts that there are significant economic costs to
dishonesty between a buyer and a seller, and this thesis is best explained with the market for second hand cars.
According to Akerlof, there are two types of used cars – good ones and bad ones (also known as lemons). On the
one hand, in a second hand market prospective buyers purchase a car with lack of information about the quality
of the product. On the other hand, the owner, after managing a certain car, has observed whether the machine has
malfunctioned in some areas or have shown outstanding results. His own estimate is far more accurate than the
judgment of the potential buyer. Hence, asymmetrical information has arisen; consequently, price does not serve
as a signal for market clearing level any more. The existence of informational disorder violates one of the main
assumptions of the Invisible Hand process; hence, prices no longer measure desirability and scarcity, and are
unable to allocate resources efficiently. What is more, good cars and lemons must sell at the same price, since
the buyer is unable to differentiate between the products. In order to inform themselves better, buyers of a certain
product either use market statistics to judge the quality of the desired good, or use specialized assistance of a car
mechanic. Both of these options give rise to transaction costs.
To conclude, dishonesty between market participants creates information asymmetries with a negative
economic impact. The cost of dishonesty consists not only in the amount by which the purchaser is cheated but
also in the “thinning of the market”, nearly driving it out of existence. In a market with information asymmetries
self-interest of market participants does not meet society’s best needs, contrary to Smith’s argument.
Joseph Stiglitz – Inefficient allocation of the labor market
In the prize lecture “Information and the Change in the Paradigm in Economics” in 2001, Stiglitz
opposes the Classical Economics View and that of Adam Smith – that if free markets were left on their own,
unemployment could be eliminated and an optimal division of labor could be achieved, since markets would be
much more price flexible. Stiglitz asserts that significant wage and price flexibility, in times of recessions, would
actually drive the economy into a bigger recession due to even higher drops in prices and wages. Furthermore, he
rejects the hypothesis that unemployment is a direct consequence of interference either by government in setting
minimum wage laws, or by the trade unions, using their monopoly power to set too high wages. Stiglitz regards
the Invisible Hand of the Market as a nonexistent phenomenon and argues that government guidance is the key
to a healthy economy.
Joseph Stiglitz also discusses the issues deriving from the fact that distinct people have access to diverse
information. Information has an impact on decision making in both firms and households. According to the
American economist, symptoms of a market failure due to information asymmetries are events such as
recessions and depressions, accompanied by massive unemployment. Joseph Stiglitz supports his thesis on the
inefficient allocation of the labor force by giving an example for market participants who might intentionally
create informational disorder in order to profit. For instance, managers (as a matter of precaution) would like to
increase their bargaining power over a certain employee. Stiglitz regards that even an insignificant amount of
information imperfection affects equilibrium levels and keeps the Invisible Hand from optimizing the market.
Nevertheless, the economist suggests a way to combat asymmetry in information. Namely, the incentive of the
worker to establish his own ability and skills diminishes informational asymmetries in the labor market. Assume
several workers, he argues, are grouped under the assumption of similar skills and wages. Hence, the most able
would have an incentive to reveal his/her full potential and to receive more, while the rest of the group will be
left with the mean marginal product of the group. Then, the most able among the new group would also gain
incentive to reveal his ability. By continuing this process, there will be a stage of full revelation and the least
able will be the last person. The driving force behind this mechanism is competition among employees and the
desire to perform better than one’s rivals.
To conclude, the prize lecture “Information and the Change in the Paradigm in Economics”, presents
an indication of the asymmetries that diverse information causes in the market place, in particular the labor force
allocation. However, there are means to counteract information asymmetries, and reach optimization point
through competition and pursuit of one’s own interest, which implies the existence of an invisible market
mechanism if certain factors are present.
3
Nadezhda Gesheva
5.
6.
6.1
Creative Destruction vs Invisible Hand – complements or substitutes?
According to the classical and neoclassical theory, free markets are able to allocate scarce resources
efficiently, meaning that no transaction costs must be associated with the process. Yet, Akerlof, Stiglitz and
Spence provide sufficient ground to question the validity of this statement. Furthermore, even Smith emphasizes
the fact that the division of labor and the expansion of the markets necessitate costs, also known as transactions
costs. The British economist Ronald Coase was the first to state that the emergence of the firm, as an economic
organization, would not have happened, unless there were transaction costs in free markets.
The reason for certain transactions to be made by firms, and not by the market participants is that they
avoid costs related to information, negotiations and monitoring (Sedlarski 2009). Transaction costs are a useful
tool to explain the existence of institutions, markets failures, etc. Furthermore, the primary function of
institutions and firms is to decrease the level of uncertainty that market participants have against one another by
diminishing the complexity of interpersonal interactions. Taking into account game theory, institutions
contribute to the rise of cooperation and the well-being of all participants.
It is essential to discuss the interactions of firms in the market place since they are a driver of economic
dynamism. In 1942, the Austrian economist Joseph Schumpeter devoted a chapter from his paper “Capitalism,
Socialism, and Democracy” to discuss the “Creative Destruction”. There he illustrates economic evolving as a
process for a certain society (Cox 2015). Schumpeter calls “Creative Destruction” the continuous organizational
development of institutions, the rise of competition among market members, and the entry of new and exit of old
firms in the market. He envisions the industrial change that takes place as ongoing process of revolutionizing the
economic structure by destroying the old and creating a new one. The Austrian emphasizes that this is an
essential feature of capitalism, or free market economy.
To start with, capitalism encourages the implementation of new ideas, the production of new products
and the offering of new services. This dynamic environment creates competition and entrepreneurship – main
driver in the Creative Destruction process. Each firm has an incentive to introduce new products and services,
and to use the latest technology to gain bigger market share and to maximize their profits. New entrants compete
with established firms, by offering lower prices, new features, faster service, better locations and aggressive
marketing strategies. Such a market behavior is similar to the one that Adam Smith has described where the
pursuit of self-interest leads to progress.
Schumpeter further argues that the survival of a company is dependent on the innovation and new
technologies it uses in its production. If a firm fails to offer competitive prices and innovative products, (hence
losing customers), it defaults and resources are transferred from lagging sectors to allocations where their usage
will bring highest returns. By doing this, creative destruction process (or the Invisible Hand of the market)
makes scarce resources meet their best use; consequently, societies as a whole become wealthier.
An intriguing feature of this process is that benefits are not immediate while costs are. Western nations,
such as Germany, have adopted capitalism and gave freedom to the Creative Destruction, thus achieving
significant economic success. However, the constant change of lagging firms with new, better-equipped ones
creates unemployment and noise in the system. Therefore, there will always be the uncertainty factor that drives
emerging markets such as Bulgaria to choose the status quo instead of change. This results in resistance towards
economic change; it binds up the Invisible Hand of the market and impedes creative destruction.
A possible way to measure the effect of the Invisible Hand: A Comparative Analysis between Bulgaria and
Germany
For the analysis that follows, this paper presumes that the assumptions made in the IHM theory, thoroughly
described in Table 3.1 are predominantly present.
How can prosperity be quantitatively measured?
This section of the paper examines what are the underlying reasons behind the differences in prosperity
between the leader of the European Union, Germany, and a transition country like Bulgaria, also a member of
the European Union since 2007. While Germany is a founding member, Bulgaria has joined the EU eight years
ago but cooperation between Germany and Bulgaria started one hundred years ago. During World War I and
World War II they were allies and were politically and economically dependent on one another. The commercial
relations were mainly Bulgarian exports to Germany. Although the initial relations between the two nations had
a military basis, as time passed their relations shifted to the economic and scientific sphere. Today, around 5 000
German companies operate in Bulgaria, and a similar number of Bulgarian students attend German universities
in addition to the tens of thousands of Bulgarian citizens who live and work in Germany (Ministry of Bulgarian
Foreign Affairs). Furthermore, various conferences such as the "Bulgarian-German Scientific Cooperation –
Past, Present and Future" outline the benefits of collaboration between scientists from both countries in diverse
areas of science (Humboldt Union in Bulgaria). In 2013, Germany became Bulgaria’s main trading partner and
the largest buyer of goods produced in Bulgaria worldwide (Federal Foreign Office). Thus, Bulgaria follows
closely the steps of the leader of the European Union towards its way to prosperity.
But how does one measure economic prosperity? Gross domestic product is a good starting point and
yet sometimes countries owe their high GDP to the increase in the inputs of the production function, namely the
4
Nadezhda Gesheva
6.2
number of people employed and the level of capital in the economy. Interestingly, there are instances where a
country has experienced an economic boom while the levels of labor and capital have been decreasing (Ganev
2005). This fact raises the question of whether there is another factor, namely an essential feature of capitalism
that drives the economy into expansion. Robert Solow gives answer to this issue in 1957 when he published a
paper called “Technical Change and the Aggregate Production Function”. There he argues that the growth of the
gross domestic product is directly dependent not only on the relative change in capital and labor, but on the
relative change in a third factor as well(please, refer to equation 1). Technological progress is the missing
variable in the equation of economic growth. Apart from the impacts that labor and capital have on real GDP,
there is an emphasis on the substantial contribution that Total Factor Productivity (TFP) has. It might be
considered also as the Solow residual – the contribution of the human capital and machinery efficiency
combined with the introduction of new technologies and policies. In this study, total factor productivity,
technological progress and Solow residual are used interchangeably. Equation (1) illustrates the Cobb-Douglass
aggregate production function:
,
(1)
or equivalently,
,
(2).
The growth equation comprises of labor input, capital input and technology/productivity level. Lt is
measured by the total number of hours worked in the current year; Kt – the real value of machinery, equipment
and buildings in the current year; and At – as a residual of the technological advancements and level of
development for the current year. Furthermore, alpha and beta are the output elasticities of capital and labor,
respectively. Assuming perfect competition, alpha and beta should sum up to 1.
This paper relies on Growth Accounting Approach3 as a method to compute the rate of technological
progress measured as a residual from equation 1. Data on Yt and Lt is available, while data on Kt could be easily
generated with the capital formation series. Then, At could be calculated as a residual value from the equation in
growth rates:
,
(3)
For further details on the computation of the residual, please refer to Appendix A.
Drivers of economic prosperity – The Freedom Index Indicators
The main debunkers of the IHM, such as George Akerlof and Joseph Stiglitz, do not take into account at
all the “self-correcting” tendencies of the economy in a longer period of time. In particular, Stiglitz overstates the
need of government intervention in the economy. The government should help improve an economic downturn
not by a direct intervention that would create insecurity in the system, but indirectly by adopting policies that
encourage research and development, saving and investing, free trade and secure property rights. Most
importantly, it must provide a legal and political framework that supports private sector activities and enables
them to attain optimal level of production. This legal and political framework is called the Economic Freedom
Index. Economic freedom is a term used to measure the ability of every human to regulate his or her own labor
and property. In an economic free society, government refrains from active interaction in the market sector and
its main role is to provide liberty and protection of the individual. In such societies, citizens are free to consume,
produce, invest and save as they will (About the Index).
Economic freedom is formed on ten qualitative and quantitative elements, divided into four extensive
types: Rule of Law, Limited Government, Regulatory Efficiency, and Open Markets.
The first one includes two indexes – Property Rights and Freedom from Corruption. To begin with,
Property Rights index is a valuation of the ability of citizens of a country to own private property that is secured
by laws; furthermore, the index assesses their ability to enforce contracts. Additionally, it is a measurement of
the strictness with which these laws are enforces by the government as well as it is a proxy for the independence
of the judiciary and the existence of corruption within it. A higher score on this index is interpreted as a good
legal protection of the property, while a lower score means corruption and possible expropriation. On the one
hand, data on Bulgaria suggests that during 1995-2013 the country’s property rights actually deteriorated from
50(out of 100) basis points in the first half of the period to 30 in the second half of the time span. On the other
hand, Germany’s score remains constant at 90 through the observed period, suggesting an efficient court system
and secured private property (please, refer to Figure 6.2.1.).
3
Instead of employing the Growth Accounting Method in Section 6, some economic scholars use econometric
approach to assess of the significance of the given factors as a driver of total factor productivity. In the current comparative
study of Bulgaria and Germany, the econometrics approach is not preferred due to the limitation of the available time series
data for Bulgaria and Germany (annual data for the time span 1995-2013) that would generate inconsistent results.
What is more, forecasts on what will be the trend in the TFP gap two years from now could also be conducted with
the use of econometric models. Analysis with current data shows that TFP gap is an AR (1), meaning an autoregressive
process of order one with high persistence. These provide a basis for future research.
5
Nadezhda Gesheva
Figure 6.2.1.: Property Rights Index for Bulgaria and Germany (1995-2013)
Source: Heritage Foundation
The second component in Rule of Law is Freedom from Corruption. The data for it is obtained from
Transparency International’s Corruption Perception Index. Again, a high score on this component means very
little corruption, while a low score indicates a corrupt government and an erosion of economic freedom. Data
analysis shows an average of 35.5 for Bulgaria and an average of 80.3 for Germany for the specified time period
(please, refer to Figure 6.2.2.).
Figure 6.2.2.: Freedom from Corruption Index for Bulgaria and Germany (1995-2013)
Source: Heritage Foundation
What is more, Limited Government is based on indexes such as Fiscal Freedom and Government
Spending. The first factor is an indicator of the tax burden set by the government. It is an average measure of
three types of tax in a certain country – top marginal rate on corporate income, top marginal tax rate on
individual income and total tax burden as a percentage of the gross domestic product. When the three factors are
averaged together, they make up to 100 basis points.
It is essential to emphasize that with the introduction of the flat tax rate in Bulgaria in 2008, the average
economic growth rate became higher (Vasilev 2015b), whereas the size of the grey economy in Bulgaria
diminished (Vasilev 2015c). These effects can be observed in Figure 6.2.3 as Bulgaria has made a tremendous
jump from a score of 46 in 1995 to 94 in 2013, however the low level of taxes comes at the expense of adequate
public services. Germany has also improved but not as much – from 33.2 in 1995 to 61.8 in 2013 (also available
in Figure 6.2.3.).
6
Nadezhda Gesheva
Figure 6.2.3.: Fiscal Freedom for Bulgaria and Germany (1995-2013)
Source: Heritage Foundation
Government Spending is the second element in the Limited Government category. State expenditure
(including consumption and transfers) as a percentage of GDP is accounted for there. According to the index,
there is no ideal score on this criterion, since it varies across countries. Nonetheless, research (Riedl 2008;
Stratmann and Okolski 2010) has shown that economic dynamism is negatively affected by a high government
expenditure that causes budget deficit and results as a sovereign debt. Therefore, a high score on the Government
Spending component indicates a moderate or even low amount of government interference in the economy.
Bulgaria’s average score is 51.6 with latest observation in 2013 of 64.2, suggesting that the Bulgarian
government’s role in the economy has decreased slightly. In contrast, Germany’s average score through 19952013 is 32.3 and in 2013 – 37.7 (please, refer to Figure 6.2.3).
Figure 6.2.3.: Government Spending Index for Bulgaria and Germany (1995-2013)
Source: Heritage Foundation
The next element, Regulatory Efficiency, rests on three types of freedom – Business, Labor and
Monetary (please refer to Figures 6.2.4, 6.2.5, 6.2.6). A proxy for the State regulation of business is the Business
Freedom Index. It is comprised of ten equally weighted elements obtained from the Doing Business report by the
World Bank. Namely, these are – starting a business (the number of procedures, cost, time and minimum capital
requirements it is necessary to start a business), obtaining a license (measuring the number of procedures, the
cost, time necessary to obtain a license), and closing a business (time, cost and recovery rates). Germany’s score
on Business Freedom is high, but in the studied time period it increases by only 7 basis points (from 85 in 1995
7
Nadezhda Gesheva
to 92 in 2013), while Bulgaria has marked a significant improvement of 18 basis points (from 55 in 1995 to 73 in
2013).
Figure 6.2.4.: Business Freedom Index for Bulgaria and Germany (1995-2013)
Source: Heritage Foundation
The second component of Regulatory Efficiency, the Labor Freedom, is an overall measure of the
regulatory framework of the labor market that comprises of six equally weighted elements- ratio of minimum
wage to the average value added per worker, rigidity of hours, hindrance to hiring an additional employee,
difficulty of firing a redundant worker, legally mandated notice period, and mandatory severance pay. Data on
these components is again extracted from the Doing business research of the World Bank. Data on Labor
Freedom in 1995-2004 is unavailable. However, data from 2005 to 2013 suggests that Bulgaria has an average
score of 79.7, while Germany is lagging behind with an average of only 43.6. Results indicate that the Balkan
country has as twice as freer labor market than the leader of the European Union. An underlying reason behind
these scores is the fact that Bulgaria has a uniform minimal wage, while Germany has a minimal salary per
sector, meaning larger government intervention. Furthermore, the labor market is highly unionized in Germany
with larger labor taxes (Vasilev 2015a). Yet, one should emphasize that those come along with accredited and
sometimes free of charge public services.
Figure 6.2.5: Labor Freedom Index for Bulgaria and Germany (1995-2013)
Source: Heritage Foundation
The third element of Regulatory Efficiency, Monetary Freedom, is calculated with the use of factors
like price stability and price controls. Ideally a free market possess price stability without intervention, since
both price controls and high inflation creates noise in the market that disrupts economic dynamism. Germany
remains constant at an average of 84.8 points throughout the observed period. Due to the hyperinflation in 1997
in Bulgaria, its average score is 20 between 1995 and 2002, but more recent observations provide evidence for a
tremendous advancement in Bulgaria with an average monetary freedom of 76.6 basis points. This “catching-up”
8
Nadezhda Gesheva
effect of Bulgaria’s series to the German ones is due to the adoption of the Currency Board in Bulgaria, fixing
the currency to the German mark and consequently to the euro. Furthermore, the Bulgarian monetary policy
closely follows the one conducted in the European Central Bank.
Figure 6.2.6.: Monetary Freedom Index for Bulgaria and Germany (1995-2013)
Source: Heritage Foundation
And last, but not least, key elements in Open Markets are Trade Freedom, Investment Freedom and
Financial Freedom (please, refer to Figures 6.2.7, 6.2.8, 6.2.9.). The first component is an indicator for the
absence of tariff and non-tariff barriers. The trade freedom relies on the trade-weighted average tariff and a
penalty is accumulated in case non-tariff barriers such as price, quantity, investment or customs restrictions as
well as direct government intervention (e.g., with subsidiaries) exist. The Balkan country and Germany have a
Trade Freedom average of 70 and 81, and a standard deviation of 14 and 4, respectively. Moreover, data shows
that Bulgaria is converging towards Germany’s Trade Freedom levels since 2008, which is only natural because
in 2007 Bulgaria entered the European Union Customs Union (EUCU), and since then both countries enjoy free
mobility of goods, meaning zero tariffs on goods within the EUCU.
Figure 6.2.7.: Trade Freedom Index for Bulgaria and Germany (1995-2013)
Source: Heritage Foundation
Furthermore, a country is economic free if no constraints on the flow of investment capital exist. In such
a country each individual and firm would be able to move without restrictions their resources internally as well
as across borders. A score of hundred on the Investment Freedom Index suggests the above mentioned criteria
are satisfied. In this component Bulgaria’s performance has deteriorated, falling from 70 in 1995 to 50 in 2013,
whereas Germany has excelled with an increase from 70 in 1995 to 85 in 2013.
9
Nadezhda Gesheva
Figure 6.2.8.: Investment Freedom Index for Bulgaria and Germany (1995-2013)
Source: Heritage Foundation
And finally, Financial Freedom means banking efficiency with independence from government
interference. State ownership of financial institutions hurts competition and the variety of services offered and
such a country scores low on this index. In particular, Bulgaria and Germany’s average scores are the same 56.8, yet in 2013 the former scores 60, while the latter - 70. The average score indicates that in both EU
countries there is a significant government interference with not fully independent central bank and both the
Bulgarian and the German governments control certain share of the financial intermediaries. As illustrated by
data, a financial convergence between the two countries is present and it is only natural considering integration
within the Eurozone.
Figure 6.2.9.: Financial Freedom Index for Bulgaria and Germany (1995-2013)
Source: Heritage Foundation
All the categories – Rule of Law, Limited Government, Regulatory Efficiency and Open Markets contribute with equal weight to a country’s overall economic freedom measure. The above made discussion of
the components of the Freedom Index Indicators gives significant evidence in favor of placing Bulgaria in the
moderately free economies with an Overall score of 66.8 and 55th place worldwide. While Germany falls into the
group of mostly free economies and occupies the 16th position with an Overall score of 73.8.
Figure 6.2.10.: Overall Freedom Index for Bulgaria and Germany (1995-2013)
10
Nadezhda Gesheva
7.
7.1
Source: Heritage Foundation
Dynamic Correlation Analysis between TFP and Freedom Indexes
The paper continues with a discussion of whether the listed economic freedom indicators are significant
drivers of productivity and prosperity in Bulgaria, as a representative of a transition economy with a lower
economic freedom, as well as in Germany, as an instance of a developed and mostly free economy. Growth
accounting method provides the means to measure the Solow residual, also referred to as total factor productivity
(please, refer to table 1B in Appendix B).
Dynamic Correlation between Bulgaria’s TFP and Germany’s TFP levels with the Overall Freedom Index
Indicator
Step one in this empirical part of the paper calculates the correlation coefficient between total factor
productivity and the Overall Economic Freedom Indicator with 19 observations in the time span of 1995-2013.
The time series has been detrended with the use of Hodrick–Prescott time-series filter applied in the statistical
package Stata. This approach will put emphasis on the generated correlation in the current period as well as on
the most significant correlation with the use of maximum 9 lags (half the number of all observations). The
highest correlation coefficient will point out the years needed for a change in the Freedom Index Indicator to
have its thorough effect on the level of productivity. One would expect that a change, say in Government
Spending Index, not to have an immediate impact on the current level of total factor productivity. Reasoning lies
on the economic theory that a change in policy is followed by a slow response in economic levels, i.e. there is an
adjustment process to the new implementations that could take up to several years. Additionally, if indeed freer
societies are more prosperous, then one would rely on a positive and significant correlation between the Freedom
Indexes and following periods of total factor productivity.
Analysis on dynamical cross-correlations of the detrended time series suggests that Bulgaria’s
contemporaneous correlation between TPF and The Overall Freedom Index scores the moderately low value of
0.16, whereas Germany’s correlation reaches the moderately high value of 0.38 (please, refer to table 2B in
Appendix B). Both correlation coefficients are positive and significant. An essential observation to be made is
that the most significant correlation coefficient for Bulgaria is between 4th and 5th lag with values on average of
0.51. While Germany scores the highest in its contemporaneous effect with a diminishing rate in the lag
structure.
The output for Bulgaria suggests a unit change in the Overall Economic Freedom Index causes
approximately 0.51 positive change in the level of productivity given enough adjustment time given (in this case
in the range of 4-5 years). This founding could be a signal that the changes in policies associated with the
Freedom Indices initially create noise in the Bulgarian system, while the full potential of such a change on
productivity levels reveals in the medium term. Hence, there will always be the uncertainty factor that drives
societies such as Bulgaria to delay the economic change. As already discussed, this binds up the Invisible Hand
of the market and impedes Schumpeter’s Creative Destruction in the short term.
The most significant lag correlations for Germany are between the 1st and 2nd lag with values on average
of 0.28, however, contemporaneous correlation remains the highest (equal to 0.38), suggesting that Germany’s
economy feels the thorough effect of a policy change more rapidly. This result is a proof that the Western nation
gives more freedom to the Creative Destruction process, thus achieving significant economic success in the short
term.
11
Nadezhda Gesheva
7.2
Correlation between the TFP gap of Germany and Bulgaria with the respective gap in their Freedom Index
Indicators
The following step is to verify whether the gap in the productivity levels of Bulgaria and Germany are
again significantly correlated with the respective gap in their Freedom Index Indicators. In such a case, this
would be clear evidence in favor of the thesis that the difference in the level of productivity is due to the
differences in the levels of freedom of the economy, i.e. that mostly free societies such as the German one owe
their prosperity to fast implementation of policies in the economic sector due to guidance by an Invisible Hand,
while a moderately free society such as the Bulgarian one is lagging behind its target due to a slower response to
innovations, resistance to change and thus a deviation from the assumptions that allow the Invisible Hand to
work.
The gap between the leader of the Euro-zone and the Balkan country is indeed correlated with the gap in
their Freedom Indexes (please, refer to Table 7.2.1).
Table 7.2.1.: Dynamical Correlations between the gap in TFP levels between Germany and Bulgaria and their
respective gap in the Freedom Index Indictors
Most
Gap correlation
Current
1 Lag
Significant
Value of MSL
(Ge - Bg levels)
Correlation
Lag (MSL)
A with Overall
0.294
0.112
1
0.112
A with PropR
0.050
0.172
4
0.479
A with FrCorr
0.771
0.642
1
0.642
A with FiscFr
0.066
0.072
5
0.258
A with GovtSp
0.242
0.375
2
0.377
A with BusFr
0.374
0.303
4
0.341
A with MonFr
0.058
0.017
1
0.017
A with TradeFr
-0.574
-0.567
7
0.165
A with InvFr
-0.368
-0.366
8
0.626
A with FinFr
0.742
0.593
1
0.593
Source: Own Estimations
The conducted analysis shows that a unit decrease in the Freedom from Corruption gap and Fiscal
Freedom gap would lead to a significant decrease in the productivity gap by 0.77 and 0.74 units, respectively
(i.e. a significant and positive correlation). A possible reason behind these coefficients is the fact that Germany
scores high on both components and mostly remains constant while Bulgaria is at the bottom of the chart on the
first criterion.
What is more, this study has found moderate correlation coefficients between the TFP gap and the gap
in Government Spending and Business Freedom. They have positive moderate contemporaneous correlation with
values of 0.24 and 0.37, respectively, strongly confirming the theory that less government intervention in the
economy and the easiness of doing business are vital for economic prosperity.
Additionally, the protection of Property Rights has a negligible effect on TFP in the current period;
nonetheless its significance emerges in the 4th lag with a high value of 0.48. A similar trend emerges with the gap
in Fiscal Freedom – it has an insignificant contemporaneous correlation of 0.05 and a moderate 0.26 in the 5th
lag. These two observations provide evidence in favor of the theory that the economy is sometimes slow when
incorporating policy changes. The gap in Monetary Freedom, i.e. price stability, seems insignificant for the TFP
gap in both current and lagged periods, which is counter-intuitive. However, both countries are under the control
of The European Central Bank, implying that both countries follow the same monetary policy. Thus, the
conducted analysis shows that the different productivity levels are not caused by the monetary component, in
particular for the case of Bulgaria and Germany.
Output indicates that a unit increase in gap of Trade Freedom and Investment Freedom would lead to a
significant decrease in the productivity gap by 0.57 and 0.37 units, respectively (i.e., a significant and negative
correlation). A possible reason behind these coefficients is the fact that both states score high on those
components, on average for Bulgaria – 60 on Trade Freedom and 57 on Investment Freedom, while the mean for
Germany is 82 on both Trade and Investment Freedom. Still, there is room for improvement on Bulgaria’s score
in order to catch up to Germany. There has not been much volatility throughout the observed period (19952013), which might be a factor affecting the consistency of the generated results. Still they are counter-intuitive
and provide basis for future research. Due to limitations in the Labor Freedom Index on both series, no
correlation coefficient has been calculated (only 8 observations are present starting from 2005).
On balance, correlation between the gap in TFP and the Overall Economic Freedom Index Gap between
Germany and Bulgaria is equal to the moderately high score of 0.29 (please, refer to Figure 7.2.2). Six out of
nine calculated correlations support the thesis that differences in prosperity between countries like Germany and
12
Nadezhda Gesheva
Bulgaria rely heavily on the independence, reliability and effectiveness in their financial and business sphere,
government sector, protection of property rights, fiscal and anti-corruption policies. Hence, the pursuit of market
participants’ own interest guided as if guide by an Invisible Hand leads societies to a better performance.
Figure 7.2.2.: Correlation between the TFP gap between Germany and Bulgaria and their respective gap
in Overall Freedom Index for the period 1995-2013.
Source: Own Estimations
8.
Bulgaria’s convergence to Germany
In economic literature convergence is defined as the hypothesis that poor countries grow at a faster rate
than rich countries, and eventually catch up with them. The theory speculates that in long term both poor and
wealthy economies converge in terms of income per capita. Nonetheless, convergence as a hypothesis could be
also interpreted as adopting best practices, a strong driver behind Total Factor Productivity.
A paper published in 2010 by Di Liberto and Usai, called “TFP convergence across European regions: a
comparative spatial dynamics analysis” examines the TFP convergence across the Europe region. Even though
the report of Di Liberto and Usai shows absence of TFP convergence among the EU15 (Bulgaria is not a
member) in the time span of 1985-2006, the present study identifies a convex and monotone downtrend in the
difference between Germany’s and Bulgaria’s Total Factor Productivity from 1995 until 2013 (please, refer to
Figure 8.1). The TFP gap was defined as the difference in levels between the Solow residuals of Germany and
Bulgaria obtained from the economic equation of growth (please, refer to equation 1 in Section 6.1 and
Appendix A). This founding implies that Bulgaria is slowly but consistently catching up with the TFP levels of
the leader of the European Union during the period 1995-2013.
Figure 8.1.: Gap in Total Factor Productivity levels between Germany and Bulgaria shows a monotone
and decreasing trend in the time span 1995-2013.
Source: Own Estimations
The monotone and decreasing relationship between the gap in Bulgaria’s and Germany’s TPF levels
implies that they converge to distinct TFP levels but to the same steady state growth rates of TFP, suggesting an
existence of a conditional medium-term convergence. This result is explained by taking saving and population
13
Nadezhda Gesheva
9.
9.1
growth as exogenous (Mankiw et al. 1992), and taking into consideration the fact that a developing country,
Bulgaria, replicates the production methods, technologies, and institutions of a developed country, Germany.
Furthermore, the significant decline in the period 2004-2013 in the TFP gap depicted in Figure 8.1 is
best motivated by fact that in the mid-2000s, Bulgaria has started adopting the EU Chapters that represent the
basis for accession to the European Union. They correspond to various reforms in administrative and
institutional infrastructures as well as integration of Bulgaria’s national legislation to the legislation of the EU. In
2007 Bulgaria was accepted as a member of the European Union, thus becoming a part of a dynamic business
environment, modern and socially friendly economy that thrives for high growth and employment. Economic
integration between the Partner countries - Bulgaria and Germany, lies at the heart of free trade agreements,
cooperation and the unifying structure of sectoral policies across all EU members.
However, the observed 1995-2013 time period is short and could only serve as a signal for a potential
initial long term convergence. Further research is needed following these lines once a more substantive and
longer data sample is obtained to determine whether indeed a long term convergence pattern is present in the
data series.
Policy Recommendations for facilitating the Invisible Hand in Bulgaria
This paper also aims at providing policy recommendations aiming at decreasing the Germany-Bulgaria
TFP gap even at a faster rate than the one already observed. Data shows that Bulgaria is lagging behind Germany
in its Property Rights, Freedom from Corruption and Investment Freedom Indexes the most out of all ten
Freedom Index Indexes.
Guidelines for the Rule of Law component
Two of the above mentioned Indexes are included in the Rule of Law, implying that Bulgaria is
predominantly lagging behind its target country in this component. No degree of substantive law improvement
would bring the Rule of Law to Bulgaria without an agile enforcement, and a sound judiciary is the core to
enforcement (Dam 2006). Each society needs institutions to resolve disputes and state structures to enforce
property rights and contracts. If such mechanisms are not implemented then transactions are limited to simple
trades, bearing high risk, while productive investments are constrained.
Data provided in this paper implies that during 1995-2013 the greatest Freedom Index gap between
Bulgaria and Germany is Property Rights. On this Freedom Index Germany has been steady at a high grade of
90 out 100, whereas it has been deteriorating in Bulgaria, increasing the gap even further in recent years. The
Balkan country must consider placing this component in its list of top priorities that should undergo
improvement. Roumeen Islam, a scholar at the World Bank (WB), discusses in her 2003-paper “Institutional
Reform and the Judiciary: Which Way Forward” that when judicial systems are strong, countries tend to have
larger companies operating. Another observation made in the WB paper is that some states in Brazil with better
judicial system tend to have more developed credit markets. Naturally, creditors avoid taking credit when unable
to enforce repayment for their services. In Bulgaria the court system is ill-functioning, and hence companies are
forced to be involved in a “relationship business”, meaning that they are obliged to contract with those they have
already established firm business relations. As already discussed, prosperous economies allow Schumpeter’s
Creative Destruction process to take place, i.e. innovation, entrepreneurship and competition guide the market
place. However, the political and economic environment in Bulgaria is constraining companies from undertaking
potentially profitable opportunities. Furthermore, these limitations restrain the extent to which businesses are
able to protect themselves from no longer profitable business relations. To conclude, the independence of the
judiciary and the ability of individuals and business to enforce contacts is vital for achieving business integrity
and hence an economic dynamism.
It is essential to emphasize that public and private institutions influence the incentives and performance
of agents in the judicial system (Roumeen Islam 2003). On the one hand, private institutions, as a part of an
accountability mechanism, affect the reputation of judges and lawyers; hence their performance as well. On the
other hand, the State has the authority to sets rules for judges’ promotion for efficient performance and penalties
for underperformance. When applied swiftly, these can determine how court cases are conducted - access to
them, their duration, meaning how long they stay in court and fairness associated with them.
Additionally, external agencies, domestic or international non-governmental organizations, media
journalists, or policy institutes overseeing the judiciary also affect its performance in two broad directions.
Firstly, they monitor and gather information on court processes and their outcomes, and secondly they circulate
the information, making it publicly available. The poor performance of the judiciary and the disregard of
property rights suggest that such a feedback mechanism is ill-functioning in Bulgaria in the recent years. And
public awareness needs to be addressed along these lines. In 1816 Benjamin Constant, a French political
philosopher, argues in his speech “The Liberty of Ancients Compared With that of Moderns” that political
liberty and awareness is inseparable from individual liberty and well-being. Hence, a priority for Bulgaria’s
prosperity is to implement changes in the current judicial system.
Designing a judicial reform, however, is complicated due to the small amount of information and
research made on developing economies. Interestingly, the “best practices” for a specific country are not always
14
Nadezhda Gesheva
9.2
to follow the international laws (i.e., for Bulgaria to follow Germany’s Anti-Corruption policies), but rather to
follow similar practices regarding institutions in neighboring countries (Islam 2003). And since the gap in the
Freedom from Corruption Index is the next issue to be analyzed, Bulgaria’s Northern neighbor – Romania,
emerges as a bright example for Anti-Corruption policies and enforcement.
To begin with, Romania’s GDP growth is 3.8 (%, year-on-year), being the economy with 5th largest
growth rate in Europe as of October 2015. Furthermore, the European Commission 2016 Forecast Report on
GDP growth for Romania is 3.3 (%, year-on-year), whereas Bulgaria’s is 1.3 (%, year-on-year). These
estimations comprise a significant 2 (%, year-on-year) difference between the two neighboring countries which
have entered the European Union concurrently in 2007. These data imply that Bulgaria is lagging behind a
similar to its recent history post-communist country, and an underlying reason is the strength of the judiciary and
the Anti-Corruption policies in place. For the last four years, Romania’s Supreme Court has: sentenced the
former Prime Minister, Adrian Nastase, to two years of prison for involvement of a corruption scandal; arrested
the Bucharest’s mayor for allegations of taking bribes; and, charged the former Prime Minister Victor Ponta with
accusations for fraud. These anti-corruption practices have a strong and positive effect on Romania’s economy,
furthermore, they earn praise from Romania’s Economic Partners for its efforts to combat corruption. From an
economics point of view, unless Bulgaria follows similar to Romania’s solid Anti-Corruption practices, it would
be exposed to insecure economic transactions that would continue to hamper economic dynamism.
Guidelines for the Investment Freedom component
The large gap in Investment Freedom between Germany and Bulgaria is the third and last component
that the study will analyze. Moreover, it will provide Bulgaria with recommendations for improvement on this
issue. As already defined, Investment Freedom measures the constraints associated with the flow of investment
capital internally and across borders. Bulgaria has performed poorly on this criterion, with a decrease in its score
from 70 in 1995, reaching 50 in 2011 and finally stabilizing to 65 in 2015 (please, refer to figure 6.2.8 in Section
6.2).
What might be the reasons behind these fluctuations in the Bulgarian Index? The precise method of
computing this particular Index is by subtracting points from the ideal score, meaning 100. A negative influence
is measured by several factors such as the existence of national treatment of foreign investments, burdensome
bureaucracy, restrictions on land ownership or sector investment, capital and foreign exchange controls.
Bulgaria is a party to 63 bilateral agreements for mutual protection and stimulation of foreign
investment. In addition to them, Bulgaria has signed the Encouragement of Investment Act (EIA) which provides
for equal treatment of local and foreign investors in the Balkan country (Investment in Bulgaria 2015). This Act
regulates the encouragement of initial investments in both tangible and intangible long term assets, as well as the
creation of new job opportunities, in compliance with regulations by the European Union. The EIA gives various
stimulus privileges for both local and international investors who undertake large investment projects within the
territory of Bulgaria. These measures are financed by the government and their goal is to improve the business
environment.
One would bring up the question why is then Bulgaria lagging behind in Investment Freedom if the
country is involved in Acts and bilateral agreements whose function is to safeguard the free flow of investment
capital. The due diligence with which these contracts are implemented might be the underlying reason for the
bad performance of Bulgaria in Investment Freedom. Recent government decisions caused damage, either
indirectly or directly, on the Index.
Firstly, Bulgaria’s poor performance might be due to the burdensome bureaucracy that both foreign and
local investors are confronted to. According to the Doing Business Report by the World Bank, in order to start a
business in Bulgaria, you need to go through at least 4 procedures and 18 working days, whereas for obtaining a
construction permit the number of procedures increases to 16 and the number of days jumps to 110. This delay
increases immensely investment costs, causing return on investment to drop and hence Total Factor Productivity
rises with lingering rates.
Secondly, in 2014 the Bulgarian National Assembly approved a five-year residency requirement for the
purchase of agricultural land by non-EU foreign investors, which certainly had a negative effect on the
Investment Freedom score. A Parliament amendment of the law in 2012 (stating that a strategic infrastructure
project could receive a preferential expropriation regime) damaged private property laws, and decreased even
further the investment incentives of foreigners. In 2013 after a Constitutional Court decision on a land owner
plaintiff, the State limited the prior preferential treatment strategy for key infrastructure projects. Currently, three
major motorways are under construction with forecasts to be completed in 2020 – Struma (part of Pan-European
Corridor IV), Hemus (connecting the capital city with Varna), and Black Sea (connecting numerous coastal
cities). Such infrastructure projects will certainly improve the efficiency with which goods, services and people
are transported. Nevertheless, in order to improve investment incentives in Bulgaria, the expropriation of these
lands needs to be done in a prudent manner with fair compensation of the private property owners.
Last but not least, as already largely discussed in the beginning of this section, corruption is a vicious
disease that infects various sectors of the economy. Due to weak judiciary performing poor enforcement of the
15
Nadezhda Gesheva
law and the lack of concrete Anti-Corruption practices, corruption might be present in staring up a business,
obtaining a license, negotiating private property owners’ compensation or simply in the execution of EU funded
projects. From an economics perspective, corruption could be regarded as an additional tax burden on capital and
investment as a whole. Consequently, investment incentives are decreased leading to a sluggish economy.
10. Summary and Conclusions
This paper transforms Adam Smith’s theory about an invisible force that drives free societies to prosperity
into an updated modern understanding of the drivers of economic success. If vital conditions are present such as
low degree of government intervention, lack of informational asymmetries, uniformity of market participants and
efficient Rule of Law, then the Invisible Hand of the market makes limited resources meet their best ends, hence
promoting economic excellence. Nevertheless, free markets and mixed market economies often suffer from the
listed above economic features which hamper economic dynamism. Two of the main debunkers of the Invisible
Hand theory, Joseph Stiglitz and George Akerlof, suggest that information asymmetries, in particular, cause
inefficient allocation of the labor force and give rise to transaction costs. Yet societies that are exposed to both
of these factors have learnt how to mitigate their adverse impact on the markets. Namely, they let Schumpeter’s
Creative Destruction process take over the market (it accounts for the industrial change of revolutionizing the
economic structure by destroying the old and creating a new one). Or equivalently, the government should help
improve an economic downturn not by a direct intervention that creates insecurity and confusion, but indirectly
by providing a legal and political framework that supports private sector activities and competition. A useful way
to assess the state provided legal and political framework is the Economic Freedom Index, which is divided into
four extensive types: Rule of Law (Property Rights and Freedom from Corruption), Limited Government (Fiscal
Freedom and Government Spending), Regulatory Efficiency (Business, Monetary, Labor Freedom), and Open
Markets (Trade, Investment, Financial Freedom).
Correlation analysis between Total Factor Productivity (as a measure of economic well-being) and the
Freedom Index Indicators of Germany and Bulgaria is conducted for the period 1995-2013. With small
exceptions, all correlations seem to be moderate and positive. For instance, Bulgaria’s contemporaneous
correlation between TFP and the Overall Economic Freedom Index is a moderate value of 0.16, with highest
significance of 0.52 in the 4th lag. In contrast, Germany’s correlation between the same factors has a more
significant value of 0.38, followed by a diminishing correlation in the lag structure. Hence, one might conclude
that a transition economy such as the Bulgarian one responds fully to policy changes within the following 4
years, whereas a mostly free economy, such as the German, incorporates policies rapidly. Moreover, the gap in
the productivity levels of both countries is also moderately correlated with the gap in their Overall Freedom
Indices with a satisfactory value of 0.29. Thus, the output provides evidence in favor of the thesis that the
difference in the level of productivity is due to the differences in the levels of freedom of the economy, i.e.
Germany owes its prosperity to rapid implementation of policies reliant on the principles of economic freedom,
while Bulgaria is lagging behind its target country due to a slower response to innovations and a lower reliance
on freedom in the economy.
Another essential founding of this paper is the monotone and diminishing relationship between
Germany and Bulgaria’s TFP levels in the time span 1995-2013, suggesting the existence of a “catching up
effect”. To extend Bulgaria’s medium-term convergence towards Germany’s TFP levels to long term, The
Balkan country needs to implement essential policy improvements in its investment incentives and Rule of Law.
To conclude, the comparative study between Germany and Bulgaria is a vivid proof that the Invisible
Hand of the Market is relevant even today. Almost 240 years after Adam Smith first considered that societies,
not hampered by excessive regulation, tend to perform better, the Invisible Hand of the Market still guides them
to prosperity.
Appendix A
Growth Accounting Approach (as derived in “Measuring Total Factor Productivity: Growth Accounting for
Bulgaria” by Ganev in 2005)
To measure Yt we use the gross domestic product, and for Lt – labor force, obtained from World
Development Indicators (WDI) Database for both Bulgaria and Germany. However, data on the variable Kt is not
16
Nadezhda Gesheva
published and it can be obtained by the Permanent Inventory Method. There is a recursive relation between the
individual components of the capital time series.
, (1)
In the above equation, It represents total investment and δ is the depreciation rate. The total investment variable
is extracted from International Monetary Fund (IMF) Database. Furthermore, the calculation of equation (1) is a
bit challenging due to the unknown level of the initial capital.
The method used for calculation of the initial capital is dependent on the depreciation rate of capital. In
this case, the δ equals 0.05 for Bulgaria (Ganev 2005) and 0.082 for Germany (Vasilev 2015a). The first
coefficient can be interpreted as the fact that full depreciation of capital occurs in 20 years in Bulgaria, whereas
in Germany it takes only 12 years.
Initial capital is calculated by the formula (2) by setting the initial capital equal to the ratio of initial
investment and the depreciation rate:
,
(2)
The conducted analysis is heavily dependent on the delta that we are using for the generation of initial
capital. Nevertheless, this effect decreases significantly in time. The further back in time the initial capital is, the
smaller the influence that its levels has on the obtained results. The already mentioned Permanent Inventory
Method represents a recursive substitution back in time. For instance, the formula for the period (t-1) is:
,
(3)
Equation (3) can be substituted back into equation (1) and the result looks like:
,
(4)
This relation could be continually applied to an arbitrary moment in time. This is the so called method of
geometric decline in capital. However, this method does not best meet our assumptions about the nature of
capital. We need capital to have finite life and to amortize for a finite amount of time. Yet, calculation based on
formula (4) with n→∞ would never converge to zero, assuming capital has infinite life. On those grounds, a
modified version of formula (4) to calculate the capital series is used:
,
(5)
In this paper, the preferred model for capital generation is the linear method. It assumes a uniform decline of the
initial capital. Moreover, the advantage of this model is that a unit of capital is fully amortized for 1/ δ number of
periods. The generated results for Bulgaria and Germany in the period 1995-2013 are as follows:
Bulgaria's capital
Germany's capital
1995
124 128 525 081
12 903 321 577 517
1996
233 973 187 489
23 575 508 596 145
1997
443 807 139 456
43 020 309 248 486
1998
842 627 989 823
78 397 963 631 779
1999
1 596 546 134 740
142 713 467 095 092
2000
3 024 826 246 510
259 659 016 317 899
2001
5 730 531 843 410
472 191 773 790 463
2002
10 854 805 713 447
858 504 353 064 718
2003
20 561 198 267 706
1 560 788 845 488 420
2004
38 946 045 326 271
2 837 373 441 641 450
2005
73 769 377 427 557
5 157 882 837 242 330
2006
139 727 783 773 461
9 376 008 146 181 050
2007
264 657 454 305 092
17 043 428 339 475 400
2008
501 284 615 611 210
30 980 669 315 124 100
2009
949 469 463 121 593
56 314 609 454 191 600
2010
1 798 367 010 318 220
102 364 870 955 834 000
2011
3 406 245 472 025 810
186 071 465 937 432 000
2012
6 451 690 619 530 030
338 226 697 939 466 000
2013
12 219 996 036 381 000
614 802 609 946 305 000
Appendix B
Table 1B
Year
Bulgaria's
total factor
productivity
(in levels)
Germany's
total factor
productivity
(in levels)
17
Nadezhda Gesheva
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
66.7425
52.1928
39.6224
31.4715
22.8329
18.6347
14.5188
11.6891
9.4624
7.6019
6.1861
4.9052
3.9652
3.1533
2.3050
1.7901
1.4045
1.0717
0.8253
1603.2074
1351.4600
1150.6945
980.8526
843.0880
730.4991
622.5835
523.6953
438.7196
370.2106
310.7001
269.3596
232.8945
197.6323
156.7001
137.1397
118.4588
101.2197
84.8819
Table 2B
Correlation between Overall Freedom Index and TFP levels
Time period
Bulgaria
Germany
Current
0.160
0.378
First Lag
0.288
0.286
Second Lag
0.388
0.281
18
Nadezhda Gesheva
Third Lag
Fourth Lag
Fifth Lag
Sixth Lag
Seventh Lag
Eight Lag
0.421
0.518
0.502
0.467
0.436
0.276
0.203
0.190
0.199
0.143
0.026
-0.128
Sources
"About The Index."2014 Index of Economic Freedom. Heritage Foundation in Association with the Wall Street
Journal, n.d. Web. 25 Oct. 2015.
Akerlof, George. 1970. “The Market for "Lemons": Quality uncertainty and the market mechanism.” The
Quarterly Journal of Economics. MIT press. Vol. 84, No. 3. pp. 488-500. Print.
19
Nadezhda Gesheva
“Bulgaria".2015 Index of Economic Freedom. Heritage Foundation in Association with the Wall Street Journal,
n.d. Web. 27 Oct. 2015.
“Bulgaria and Germany will work for a more active bilateral cooperation based on new and stronger trust”.
Ministry of Foreign Affairs. The Republic of Bulgaria. 10.03.2015. Web. 15 September 2015.
Ganev, Kaloyan. 2005 “Measuring Total Factor Productivity: Growth Accounting for Bulgaria.” Bulgarian
National Bank, Discussion Paper Series № 48, 2005. Print
“Germany". 2015. Index of Economic Freedom. Heritage Foundation in Association with the Wall Street
Journal, n.d. Web. 27 Oct. 2015.
Copley, Stephen and Kathryn Sutherland.1995 “Adam Smith’s Wealth of Nations: New interdisciplinary
essays”. Manchester and New York: Manchester University Press, p.23. Print.
Cox, W., and Richard Alm. 2015. "Creative Destruction." The Concise Encyclopedia of Economics. N.p., n.d.
Web. 26 Mar. 2015.
Dam, Kenneth W. 2006. “The judiciary and Economic Development”. John M. Olin Law & Economics Working
Paper No. 287. Chicago.
European Commission. Economic and Financial Affairs. Economies of the Member States - Romania and
Bulgaria.Web. 20 October. 2015
Federal Foreign Office. Foreign and European Policy. Bilateral Relations. March 2015. Web. 13 October 2015.
Hayek, Friedrich A. 1945. “The Use of Knowledge in Society”, American Economic Review. XXXV, No.4,
pp.519-30. American Economic Association. Print
Humboldt Union in Bulgaria. 2015 Humboldt Kolleg. Bulgarian-German Scientific Cooperation: Past, Present
and Future. Web. 12 October 2015.
Investment in Bulgaria 2015. KPMG in Bulgaria. Web. 26 October 2015
Islam, Roumeen. 2003. “Institutional reform and the judiciary: Which way forward?”. World Bank. Policy
Research Working Paper 3134.
Keynes, John Maynard. 1935. “The General Theory of Employment, Interest and Money by John Maynard”.
Harcourt, Brace and Company, Polygraphic Company of America, New York. Web. 16 March 2015.
Lee, David and Emmanuel Saez. 2008 “Optimal Minimum Wage Policy in Competitive Labor Markets”. CEPS
Working Paper N:178. Print
LeRoy, Stephen. 2010. “Is the Invisible Hand Still Relevant?”. FRBSF Economic Letter 2010-14. Federal
Reserve Bank of San Francisco, 3 May 2010. n.p. Web. 17 November 2012.
Mankiw, N. Gregory, David Romer, and David N. Weil. 1992“A Contribution to the Empirics of Economic
Growth”. The Quarterly Journal of Economics 107 2. Oxford University Press: 407–37.
http://www.jstor.org/stable/2118477.
Mihaleva, M. 2015. “Bulgaria: Expropriation revisited”. Schonerr. Roadmap14. Web. 29 October 2015
Schumpeter, Joseph. 1976 “Capitalism, Socialism and Democracy.” New York : Allen & Unwin. 1976.
Sedlarski , Teodor. 2009. “Transaction Costs in the Course of the System Transformation in Bulgaria”.
Economic Thought. Issue: 2. Print.
Smith, Adam. 1909. “An inquiry into the nature and causes of the wealth of nations.” Ed. C. J. Bullock. New
York: P.F. Collier & Son Company. Print.
Solow, Robert. 1957. “Technical Change and the Aggregate Production Function”. MIT Press. Web. 23 March
2015.
Spence, Michael. 1973. “Job Market Signaling”. The Quarterly Journal of Economics, Vol 87, No.3, pp.335-374.
Stiglitz, Joseph. 2001. “Information And The Change In The Paradigm In Economics.” Columbia University.
Prize Lecture. Print.
Vasilev, A.Z. 2015a. "Macroeconomic effects of public-sector unions”, Labour magazine.
Vasilev, A.Z. 2015b. "Welfare effects of flat income tax reform: the case of Bulgaria,"Eastern European
Economics, accepted. ISSN 0012-8775. (forthcoming)
Vasilev, A.Z. 2015c. "Welfare gains from the adoption of proportional taxation in a general-equilibrium model
with an informal sector: the case of Bulgaria's 2008 flat tax reform," Economic Change and Restructuring, Issue
2, 169-185, May. DOI: 10.1007/s10644-015-9159-5. ISSN: 1573-9414.
Walton, Gary M. and Frank C. Wykoff. 1988. “Understanding Economics today”. Boston: Irwin McGraw-Hill.
Print
20